UK economic crisis

EEP-2 REPORT(GROUP 7)
Animesh(11P066) Aditya Bansal(11P064) Anupriya Asthana(11P069) Nitin Kumar Gupta(11P094) Prithi Singh(11P099) Yashwanth Reddy(11P120)

Contents
Introduction .................................................................................................................................................. 3 Reasons for UKs Turmoil .......................................................................................................................... 5 UKs Austerity Programme............................................................................................................................ 5 Overview: .................................................................................................................................................. 7 UK economys assessment ........................................................................................................................ 8 UK economic outlook .............................................................................................................................. 11 Double dip in 2012? ................................................................................................................................ 12 favourable factors to help recovery next year........................................................................................ 14 References .................................................................................................................................................. 17

Introduction
The UK is the 6th largest economy in the world in 2010 according to nominal GDP (current prices, US dollars) and the 8th largest in the world according to GDP (PPP). In 2010, UKs GDP (PPP) was US$2.172 trillion or 2.982 percent of the worlds GDP. Presently UKs economy encompasses those of its home nations England, Scotland, Wales and Northern Ireland. The Isle of Man and the Channel Isles are also considered to be part of the British Isles but have offshore banking statuses. As a member of the EU, the UK is part of a single market that ensures the free movement of people, goods, services, and capital within member states. Nevertheless, the UK still maintains its own economy and has chosen to continue using the Pound Sterling as its national currency rather than converting to the Euro. During its heyday as the British Empire, the UK was the largest and most influential economy in the world. As the birthplace of the first Industrial Revolution during the 18th century, the UK ushered in what economic historians agree to be the most significant event in mankinds history. The UK was also able to be at the forefront of technological advances during this time, giving it a strong economic advantage over any other country in the world. However as other countries began to catch up technologically wise, UKs economy was also greatly affected by the two World Wars and the breaking up of the British Empire. Although the UK economy has since recovered, it is unlikely to reclaim its former position as the top economic power in the world. Today, the UK economy faces another struggle to recover from the 2008 financial crisis.Presently, the recovery effort has been sluggish. Although global economic prospects appear to be improving, economic forecasts for the UK have been fairly negative. In April 2011, The IMF slashed its 2011 growth forecast for UKs economy to 1.75 percent, its third downgrade in a year. A report by the Organisation for Economic Co-operation and Development (OECD) also ranked UK as the slowest growing economy in the G7, with the exception of Japan. The UKs GDP makeup is comprised of agriculture (1.4 percent), Industries (22.1 percent) and services (77.1 percent). Despite only contributing 1.4 percent of UKs GDP in 2010, Agriculture is still considered an important part of the UKs economy and society as it produces 60 percent of the UKs food needs. Agriculture in the UK is highly mechanised and efficient, combining advanced technology with modern farming

techniques. Agriculture in the UK is also highly subsidised, both by the UK government and the EUs Common Agricultural Policy. Industries and manufacturing on the other hand is extremely important if the UK wishes to reduce its trade deficit. The UK is the sixth-largest manufacturer of goods in the world according to the value of its outputs. Within manufacturing, the production of automotive or aerospace equipment is a major contributor to UK industries. UKs aerospace industry is the second largest in the world with companies such as BAE Systems (the worlds second largest defence contractor), and Rolls-Royce (the worlds second largest aircraft engine maker) boasting annual turnovers of around 20 billion. However, despite the historical importance of agriculture and industries, services remain the dominant component of UKs economy. Finance and banking are by far the UKs most important services with London being one of the three major economic command centres alongside New York City and Tokyo. Important financial institutions located within London include the London Stock Exchange, the London International Financial Futures and Options Exchange, the London Metal Exchange, Lloyds of London, and the Bank of England. Tourism is another extremely important service in the UK. With more than 28 million tourist arrivals in 2009, the tourism industry is worth nearly 80 million annually. According to tourism agency Visit London, the 2012 London Olympics will be a boost to the UKs economy providing an additional US$2.457 billion to the economy over ten years.

Reasons for UKs Turmoil

UKs Austerity Programme

Part of the reason for UKs slow economic growth has been due to the recent introduction of an austerity plan. The UK austerity plan was introduced as a method to reduce record level debts that were exacerbated by the 2008 global financial crisis. Apart from cutting public spending and services, the UK government have also implemented a new wave of tax increases. However, while these methods are fundamental in reducing debt, they tend to hamper economic growth in the short term as well. According to the Chief Economic Adviser for the Confederation of British Industry Ian McCafferty, The recovery continues to be choppy and lacking in vigour. Expansion in certain sectors is being offset by weaker performance in others. What remains striking is how little we expect the pace of growth to accelerate in 2012, and that it will be far less robust than we'd normally expect in the second and third years of a recovery. In the wake of the recent economic forecasts, the austerity plan has once again been called into question. John Evans, general secretary at the Trade Union Advisory Committee to the OECD warned that the UK austerity plan could be a vicious cycle, not a virtuous cycle. Prominent economist Nouriel Roubini also expressed concern over the likelihood of stagnation and double-dip recession.

High Trade Deficit

One direct effect of the UKs budget deficit has been the ever-increasing trade deficit that the UK suffers to the rest of the world. The UK has the second highest trade deficit in the world behind the US.In 2010, UK imports were worth US$546.5 billion with exports were valued at only US$405.6 billion. Despite recent attempts by the government to reduce the trade deficit, the latest data from UKs Office of National Statistics points to a widening trade gap. Since the beginning of 2011, UKs monthly trade deficit has hit record levels of more than 4 billion per month. The monthly deficit in the UK for 2011 is also exceeding the previous record level of 3.5 billion per month reached in 2007.

High Inflation
UKs current inflation rate is also threatening to sabotage the UKs government austerity plans to keep interest rates under control. According to Justin Knight, head of European rate strategy at UBS, What has been driving UK yields is the prospect or risk of inflation, which has to be priced in. There are distinct concerns about inflation."

In 2011, the UKs inflation rate (average consumer price change) is expected to be more than double of what the UK government had previous targeted 4.2 percent compared to 2 percent.

Overview:
The UK economy emerged from the 200809 recession with elevated public and private debt and high unemployment. Strong growth and macroeconomic stability in the runup to the crisis had hidden a buildup of significant imbalances, influenced by overreliance on debtfinance and the financial sector, and booming asset prices. These imbalances need to be addressed to ensure a sustainable and balanced recovery. The government is pursuing a necessary and wide ranging programme of fiscal consolidation and structural reforms aimed at achieving stronger growth and a rebalancing of the economy over time. A broad based recovery started in end2009, but faces significant headwinds during 2011, which can be mitigated by monetary policy remaining supportive. The planned fiscal consolidation is needed to ensure that the fiscal position will be sustainable over time. Nonetheless, it adds to the headwinds from weak real income growth and a fading rebound in global trade. Monetary policy should hence remain expansionary, even if headline inflation is significantly above target, to support the recovery. While the governments fiscal plans and reforms to the fiscal policy framework have significantly reduced fiscal risks, further improvements to the fiscal framework and reforms to make the financial sector more robust are needed. The government has embarked on an ambitious and necessary fiscal adjustment and strengthening of fiscal institutions, including the welcome creation of the Office for Budget Responsibility. Steps towards establishing a permanent fiscal framework should start to be undertaken as the public finances are returned closer to balance. The creation of a Financial Policy Committee will strengthen macroprudential policy, but further steps are needed to deal with banksthat are too big to fail. Reforms to housing policy should aim to increase affordability and mitigate excessive house price volatility by enhancing the supply of available land and reducing the volatility of housing demand. Rigid housing supply and fastrising demand have fuelled house prices, reducing affordability and contributing to macroeconomic and financial instability. Policies to increase supply should focus on lowering barriers to access to land for housing and providing sufficient incentives for local communities to allow development. The current system of housing taxation is regressive, encouraging excess demand for housing and should be modified to better reflect the value of ownership.

TABLE 1: Main economic indicators for UK

UK economys assessment
1. The global financial crisis and the associated recession ended a 15year period of continuous growth, rising employment and stable inflation. Significant imbalances had developed, however, in terms of public and external deficits, an excessively leveraged financial sector, high house prices and low household savings. The imbalances exacerbated the downturn during the global recession and contributed to a more pronounced fall in GDP, a larger fiscal deficit and higher inflation than in most of

the OECD. A wide range of policies were introduced to support the economy and the financial sector,some of which are now being scaled back. 2. The broad based recovery that started in end2009 slowed in the second half of 2010. The recovery is likely to remain subdued in 2011, as the necessary fiscal tightening and a fading rebound in world trade create headwinds, before picking up again in 2012. With general government net lending close to 11% of GDP in 2009, a substantial tightening was vital to achieve a sustainable fiscal position and reassure investors. Fiscal consolidation will impact significantly on government consumption, investment and household income growth in 201112. Financial conditions are improving, but the financial sector continues to benefit from crisisrelated support schemes and ultra-low policy rates which will eventually be withdrawn. Slow real income growth will hold back household consumption.The response of net trade to the depreciation of sterling and the recovery in export markets has so far been disappointing, although manufacturing exports have picked up strongly from a low base. But, as service exports start to recover, relative export performance is set to improve. Investment has also started to pick up and is likely to grow stronger in response to shrinking excess capacity in manufacturing and low levels of housing investment. All in all, a subdued recovery is expected over the next two years, largely driven by a rebalancing of the economy towards rising net exports and increasing investment. 3. The labour market has proved to be comparatively resilient in the recession, although unemployment has risen. Labour market adjustment comprised a significant fall in real wages due to high inflation, but also due to nominal wage restraint and shorter average working hours. The labour market recovery is expected to be slow, reflecting a subdued recovery, spare capacity among firms and shrinking public employment. Unemployment is expected to fall gradually. Low skilled workers and youth have been particularly hard hit during the recession, pointing to the importance of maintaining efficient employment services, strengthening work incentives and improving educational outcomes. 4. Significant global and domestic risks remain to the projection. Household consumption may be weaker than expected in response to sluggish growth in real incomes, a further fall in housing prices or fasterthanexpected increases in interest rates. Exports may recover slower or faster, reflecting uncertainty about global demand and the longer term impact of the depreciation of sterling on exports.Furthermore, the ability of financial sector exports to recover their precrisis level is uncertain. Business investment may, on the other hand, recover more strongly than expected.

5. The government is pursuing a necessary and wide ranging programme of fiscal consolidation and structural reforms aimed at achieving stronger growth and a rebalancing of the economy over time.As discussed below, reforms to improve educational outcomes and the functioning of the housing market could raise productivity and long term growth. A simpler welfarebenefit system with stronger work incentives and stronger support for activation, as outlined in the planned Universal Credit reform and the new Work Programme, could improve labour market outcomes. Furthermore, the required fiscal consolidation will imply that private sector activity will need to lead the recovery. The government has announced reforms to corporate taxation aiming at lowering firms tax burden. The ongoing GrowthReview needs to address a range of obstacles to private sector growth.

Figure 1: Fiscal outlook and consolidation

UK economic outlook
The UK likely re-entered recession at the end of 2011. Near-term prospects are bleak with a number of headwinds hampering the recovery. In particular, falling demand from continental Europe, continuing fiscal retrenchment and weak consumer and business confidence will keep GDP growth down to only 0.3% in 2012. Unemployment is projected to rise to close to 9% by the end of this year. But growth should gather pace in the later part of 2012 and average 1.9% in 2013.Key to this pick-up in activity is an expected fall in inflation that ends the squeeze on consumers purchasing power. In addition, assuming that business confidence improves, sound balance sheets mean that companies can accelerate investment spending. We judge that there is currently a significant amount of spare capacity in the UK economy. However, growth in the capacity of the UK economy is likely to be relatively slow in the short term, constrained by tight credit conditions. We expect potential output growth to average only 1.6% over the period to 2016. GDP,however, is expected to grow on average by 2.1% a year over the next five years as the output gap gradually closes. Our short-term forecast is somewhat weaker than both the Office for Budget Responsibility (OBR) forecast and the market consensus, although in our view this discrepancy is largely a question of timing, with other forecasters -- - including theOBR -- - likely to downgrade their forecasts in the next few months. While our baseline forecast may appear to be rather gloomy, particularly in the short term, the risks remain heavily skewed to the downside. The most serious threat comes from the prospect of an escalation of the Eurozone sovereign debt crisis, with a series of defaults and exits from the Eurozone having the potential to cause another deep recession in the UK. Barring unforeseen shocks, CPI inflation should fall back to target by early 2012. Although recent inflation outturns have exceeded the 2 percent target, this overshoot reflects price level shocks related to the January 2010 VAT increase, rebounding global commodity prices, and continued pass-through from earlier sterling depreciation. Another VAT increase in January 2011 will keep headline inflation above target next year. But over time the existing margin of spare capacity, along with fiscal tightening, will impart a significant disinflationary impulse. As a result, inflation should gradually revert to target as temporary effects dissipate and economic slack keeps underlying wage and price pressures in check. Upside and downside risks are balanced, but uncertainty around the central scenario is considerable: On the upside, expansionary impulses from very low real interest rates, past sterling depreciation, and the ongoing recovery of global demand could be greater than expected, boosting the UK economy onto a faster-than-expected growth path. This scenario would likely entail higher global commodity prices and stronger inflationary pressure. However, downside risks are also sizeable, given the continued fragility of confidence, stillstrained balance sheets among households and banks, signs of renewed housing market weakness, and the possibility that headwinds from fiscal consolidation could turn out to be more powerful than expected. Although it is unlikely and not unique to the UK, an adverse

scenario where major new shocks - arising from either external forces or domestic ones - trigger another extended contraction in output cannot be ruled out. Souce: Andrew Goodwin (Oxford Economics)

Double dip in 2012?

The UK enters 2012 from a weak position The preliminary estimate for GDP growth in 2011Q4 showed that output contracted by 0.2% at the end of last year. Official monthly output estimates had shown manufacturing activity drifting down through the summer, but greater resilience in the services sector.However, the escalation of the Eurozone crisis from late July caused a sharp decline and increased volatility in equity prices, which in turn damaged sentiment amongst both businesses and consumers. This was reflected in a steep downturn across a number of the key business surveys in the autumn, but the damage to the real economy was most apparent in Octobers official monthly output estimates, with the manufacturing and services sectors having seen month-on-month declines of 0.9% and 0.6% respectively Decembers Purchasing Managers Index (PMI) surveys were less weak than in preceding months, but activity balances remained well below the levels reached in early 2011 and the new orders pipeline remained weak. We are forecasting that the UK economy will endure a technical recession in 2011Q4 and 2012Q1. The descent back into recession was caused by a range of international and domestic factors. The global economy slowed sharply during 2011, firstly because of a soft patch in the US and latterly as a result of the escalation of the Eurozone sovereign debt crisis. This has been particularly damaging for the UK because of its heavy reliance on the Eurozone for its exports (see Chapter 1). We estimate that growth in world trade, weighted by UK export shares, slowed from 13.4% in 2010 to 6.4% in 2011. The uncertainty over the future of the Eurozone has also had a negative effect on domestic demand in the UK. Surveys of business and consumer sentiment have dropped back to levels last seen during the recession of 200809, and this has translated into a reluctance to spend until the uncertainty clears. Furthermore, though weaker global growth has been reflected in lower prices across a range of commodities, including food and metals, oil prices have remained at historically high levels. Social and political tensions in the Middle East have increased concerns about supply disruptions, raising the risk premiums. As a result, retail petrol prices have barely fallen from their April 2011 peaks. And, with domestic energy bills also increasing by more than 10% in Autumn 2011, households finances have remained under severe pressure. Domestically, the austerity programme has been a significant drag on growth in recent quarters. The increase in the main rate of VAT in January 2011 added around 1 percentage point to inflation in 2011, exacerbating the squeeze on consumers. Moreover, government investment has been cut sharply. We estimate that it reduced GDP growth by 0.3 percentage points in 2011. The austerity programme has also dampened net job creation. The pace of job losses in the

public sector has been considerably faster than the OBR had originally forecast and, with economic growth faltering, the private sector found it increasingly difficult to create sufficient jobs to offset the drag from the public sector. The subsequent increase in unemployment has reinforced the pressure on households and further damaged confidence.In addition, credit conditions still remain tight relative to historical norms. Small and medium-sized firms, in particular, continue to find it difficult to access the credit they require, which is constraining their ability to invest and to expand production. Furthermore, although UK banks have not implemented the type of credit tightening seen in the Eurozone, there were signs towards the end of 2011 that higher interbank rates were beginning to increase the cost of credit, particularly for firms.

Favourable factors to help recovery next year

Monetary policy is likely to remain supportive One factor supportive to growth will be monetary policy, which is expected to remain very accommodative with the possibility of even further easing from the Bank of England (BoE).

Low bond yields Our research suggests that quantitative easing has a significant impact on longer-term interest rates. We estimate that QE equivalent to 10% of GDP depresses 10-year government bond yields by around 1 percentage point (100 basis points). The BoEs programme has therefore been a key factor contributing to the significant fall in 10-year UK gilt yields, to below 2% in January 2012. As the QE programme remains active, bond yields should stay low. In addition, UK gilts are benefiting from a safe haven status, as investors move away from riskier government bond markets, in particular in some Eurozone countries. With uncertainty about the resolution to the Eurozone crisis, or indeed the future of the Eurozone, likely to be high throughout the year, UK bond markets should remain very attractive.

Inflation to fall sharply Another support to growth is expected to come from a sharp fall in inflation, which has already begun. The bulk of the rise in inflation to over 5% during 2011 can be attributed to one-off or temporary factors, such as higher VAT or food and energy prices. As those increases fall out of the year-on-year calculation, inflation is set to fall under 2% (Figure 2.10). The most significant drop in inflation rates is likely to come in early 2012, as the impact of the increase in the main rate of VAT in January 2011 falls out.In addition, we expect further falls in oil prices this year, which will also contribute to lower inflation. Assuming that concerns over oil supply abate, slowing demand should pull Brent prices down towards $100 per barrel by the end of 2012. Non-oil commodity prices are also forecast to fall this year, on the back of weaker global demand.

References
http://www.economywatch.com/world_economy/united-kingdom/ http://www.britishchambers.org.uk/policy-maker/economic-data/quarterly-economic-survey/ http://webarchive.nationalarchives.gov.uk/20100407010852/http://www.hmtreasury.gov.uk/ukecon_imf_articleIV2009.htm http://www.niesr.ac.uk/pdf/020212_170728.pdf http://www.hm-treasury.gov.uk/ukecon_index.htm